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Exchanges of partnership interests do NOT qualify under IRS Code Section 1031, therefore when partners want to end their relationship they cannot exchange out of their partnership interests into another partnership interest or real property under Code Section 1031.
HOWEVER, a 1031 exchange can be structured to potentially allow some partners to go separate directions (i.e. cash out or do their own separate 1031 exchange) while the remaining partners go forward with a 1031 exchange in the name of the original partnership.
Here are some examples of potential structures:
1. Using single member Limited Liability Company (LLC) subsidiaries;
2. The use of a “drop and swap” method;
3. Using an Installment Note to “cash out” a partner;
4. The use of an IRC code section 704(b) special allocation of boot to
“cash out” a partner.
The most commonly used methods are either #1 or #2 above.
Here is a brief description of these scenarios:
a) “Single Member LLC” – This structure is typically used when the partners are cooperating with each other and would like to go forward with a 1031 Exchange by each purchasing separate replacement properties.
Example: John, George and Ringo are equal partners in a partnership, JGR. They are selling their Relinquished Property and want to effect a 1031 Tax Deferred Exchange, HOWEVER they each want to purchase their own separate Replacement Properties and dispose of the partnership (JGR). JGR will dispose of the Relinquished Property and will acquire 3 Replacement Properties, each owned by a newly formed single-member LLC. The sole member of each of these new single-member LLCs will be JGR. After some period of time in the future (conservatively two tax returns is suggested), the membership interest in the single-member LLCs will then be distributed to John, George and Ringo through the liquidation of JGR.
CAUTION: The key to this structure holding up in an IRS audit will be to ensure that the properties were each held for use in a trade or business or for investment, and held for a sufficient period of time to sustain the IRS’ scrutiny.
b) “Drop and Swap” - This structure may be used when a partnership owns a property which they want to sell and then go in different directions. Typically this structure is used when the partners are not cooperating with one another and wish to dissolve the partnership immediately.
Example: John, George and Ringo are equal partners in a partnership, JGR. They are selling their Relinquished Property and John and George would like to do their own separate 1031 exchanges, and Ringo would like to cash out. Therefore, the partners agree to transfer the Relinquished Property from JGR to John, George and Ringo as tenants in common, immediately before the close of the Relinquished Property sale escrow. Then Ringo cashes out by taking his portion of the Relinquished Property sale proceeds, and John and George each REINVEST their proceeds separately into suitable Replacement Property through the use of Accommodator Finance Company as their QI for their 1031 Exchange purposes.
CAUTION: Again the issue in this structure may be that the “drop and swap” method will fail the “held for qualified use” IRS requirement. At this writing there is currently conflicting IRS rulings on this issue and so we have no clear cut authority from the IRS if this structure will pass audit.
The Franchise Tax Board (FTB) has just recently advised that they have hired 100 auditors to review 1031 Exchanges within the State of California, and that they will be specifically looking at these “partnership” issues relating to the exchange. The Internal Revenue Service (IRS) has also advised that they will be more closely scrutinizing the 1031 tax deferred exchange for compliance.
It is for these reasons that you and your clients MUST utilize the services of an experienced and trustworthy Qualified Intermediary. Accommodator Finance Company (AFC) has a strong reputation in the 1031 Exchange Industry and is staffed with the highest quality professionals, ready to assist you in all you 1031 exchange transactions. While AFC is experienced in all types of 1031 Tax Deferred Exchanges, in any instance where these potential partnership structures are contemplated, we strongly advise that the Taxpayer consult with a tax advisor that specifically specializes in these types of partnership issues and is experienced in the area of 1031 Tax Deferred Exchanges.
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